Conversions of retirement accounts holding nontraditional investments introduce twists. Here's what you need to know to make the journey safe
A Roth IRA is the same thing as a traditional IRA, but with special features,1 including:
Contributions to a Roth IRA aren't tax deductible, while contributions to a traditional IRA might be.
Contributions to a Roth IRA may be made even after age 70½, as long as income doesn't exceed certain levels.
Distributions are tax free, if any Roth IRA has existed for at least five years and the taxpayer is over age 59½.
Lifetime required minimum distributions (RMDs) do not need to be made (but RMDs must begin after death).
The two most common ways to contribute to a Roth IRA are through regular contributions and through conversions of other retirement accounts. Conversions often pack more value into a Roth IRA because, unlike regular contributions that are limited to annual maximum amounts that are subject to income-based phaseouts, conversions aren't limited by size or income.
And Roth IRA conversions aren't just for marketable securities. Nontraditional investments can be converted — they just take a little extra care. So here's how to put into Roth IRAs all those nontraditional assets, like real estate, limited liability companies (LLCs), limited partnerships (LPs), private debt instruments, livestock, factoring arrangements, equipment leasing, and even tax liens. And here's why you have to be careful.
Traditional IRAs and most other kinds of retirement plan benefits can be converted to a Roth IRA by means of making a rollover within 60 days of distributing the account to be converted. Better ways to make a conversion are by direct transfer or designating an existing account as a Roth account.
If the conversion isn't working out by the income tax return due date for the year of conversion (including extensions to Oct. 15th), the account may be re-characterized to a traditional IRA and all conversion tax will be erased.
Alas, conversion comes with a price: Income taxes are paid as though the converted account underwent a taxable distribution. For example, the conversion of a $100,000 IRA will mean paying income taxes on that $100,000, assuming there's no income tax basis in the IRA. All 2010 conversions are taxed not in 2010 but ratably in 2011 and 2012, unless taxation in 2010 is elected instead. That election may be made by the extended due date of the 2010 income tax return.
Before converting, take a peek at what's in the account. There may be more than cash and marketable securities. Some have nontraditional investments such as real estate, LLCs, LPs and other instruments that may be illiquid or difficult to value. Note: these kinds of investments are attractive candidates for conversion.
With a Roth IRA, it's a big plus that there's no need to reconcile illiquidity and knotty valuation problems with paying lifetime RMDs from a non-Roth retirement account. And if the Roth IRA passes to a surviving spouse, the spouse can continue to avoid RMDs by rolling the account over to her own Roth IRA. When the spouse elects the rollover, RMDs won't have to begin until the year when a non-spouse beneficiary inherits the Roth IRA.
A few things always bear repeating before investing any kind of IRA funds in nontraditional assets:
No matter how tempting, avoid owning life insurance in an IRA or Roth IRA. To meet the definition of an IRA, owning life insurance must be prohibited by the terms of the IRA.2
It's prohibited for IRAs to own collectibles (such as works of art, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, jewelry or stamps.) Owning any collectible causes a deemed taxable distribution of the collectibles.3 Note, however, there's a special exception permitting investment in certain precious metals and coins.
Avoid owning S corporation stock. Although IRAs and Roth IRAs can own the stock without negative IRA consequences, that ownership will terminate the S election of the corporation, because IRAs are not permitted S corporation shareholders.4
You're permitted to own real estate in your Roth or traditional IRA, but you (or other related persons) may not use this real estate. Such use is a prohibited transaction that will cause the IRA to terminate. For example, staying in your IRA's vacation condominium for any reason, even while doing repairs, is a prohibited transaction.
Once you've established that a retirement account to be converted has IRA-acceptable forms of alternative investments, those investments can be transferred into a Roth IRA. While converting may be advantageous, there's a drawback: the time and cost needed to move nontraditional investments from the old account into the Roth IRA, because the converted property will have a new owner — the Roth IRA.
There's a new owner because each IRA is a trust, according to Internal Revenue Code Section 408(a).5 Even custodial accounts are treated as trusts for purposes of the IRC, and the custodian is treated as a trustee for all IRC purposes — not just the income tax portion of the IRC.6 Although all IRAs are aggregated for purposes of taxing IRA distributions,7 they aren't aggregated for any other purpose. Even when aggregated for the limited purpose of taxing distributions, traditional IRAs and Roth IRAs are not aggregated with each other.
Thus, a traditional IRA and a Roth IRA are treated as separate trusts when there's a transfer between them.
The ownership transfer must be reflected in all respects. Converting nontraditional investments often means changing title. Sometimes, it's like transferring an entire business. That can become complicated, costly and time consuming. Always be sure that the titles of all converted assets are held in the name of a qualified Roth IRA trustee or custodian.
The time it takes to transfer assets can be the difference between completing a conversion by the end of the year or not. It also can make or break a re-characterization that must be made by the extended income tax filing date. The moral is: start early.
It's not always rough going. Some custodians avoid such title changes when transferring between accounts by not placing an account number on the title, but rather identifying its customer account ownership on its own books. In such an arrangement, asset titles don't change when there's a transfer between accounts; only the account number the custodian assigns to the assets does. But there will be a title change when the custodian doesn't operate that way just as there will be when there's a change in custodians.
Operating real estate is one example of the need not only to change title, but also to substitute the transferee into the shoes of the transferor in many contractual relationships. You will need to transfer title to the Roth IRA and record it. And because the identity of the insured will have changed, you must reflect that change in the property's insurance contract. Financing arrangements must reflect a new obligor. Title insurance contracts must be examined to determine what effect on coverage the transfer might have. Likewise, all agreements, such as leases, operating agreements, or tenancy-in-common agreements, will have to be reviewed and the ownership substitution will have to made.
A glitch in any of these things can lead to operating or legal disasters.
In short, it's a good idea to engage a real estate attorney to help with Roth IRA conversions of real estate.
Some investments are held not by the retirement account but through an entity, such as an LLC or LP. To make an effective transfer, you must review the entity's agreements and identify the steps necessary to assure that the Roth IRA steps into the shoes of the transferor retirement account. For example, some agreements require formal approval for admission of a new member/partner and also require that the new member/partner agree in writing to the terms of the LLC or LP agreement.
Taxable Conversion Value
In addition to making an effective transfer, you will need to value the transferred property. The conversion income tax will be based on that valuation. If there's an annual valuation being prepared for Internal Revenue Service annual reporting, consider completing the conversion near the end of the year to avoid having to pay for an extra valuation report or update.
Once the valuation is complete, look for possible adjustments to that value for purposes of reporting the taxable conversion amount.
Let's use real estate as an example again. Real estate tax accrued through the date of transfer is an example of a liability that may be subtracted from the property value in arriving at the taxable conversion amount. On the other hand, prepaid insurance will increase the taxable amount. These accruals and adjustments are easily identified because they are common to real estate closings.
When an interest in an LLC, LP or corporate stock is transferred, it's necessary to consider whether valuation discounts apply, such as discounts for lack of marketability, restrictions on transfer, or lack of control. Note that the limits on valuation imposed solely for transfer tax purposes, such as those under IRC Chapter 14, will not apply for income tax purposes. IRC Section 2704, limiting valuation discounts on some transfer restrictions, is an example of a transfer tax provision constraining valuation discounts.
Not all nontraditional transfers are complex. Yet even the seemingly simple ones can come with traps. Precious metals are simple to transfer. Nevertheless, they must qualify in both of two ways for ownership by an IRA, including a Roth IRA.
First, the particular precious metals to be transferred must meet an exception to the list of otherwise prohibited “collectibles.”8 Second, the metals must be in the actual possession of the Roth IRA trustee or custodian who offers the account. Failure to meet either requirement causes the assets to be treated as distributed in a taxable distribution. Presumably, mistakes can be fixed during the 60-day rollover period. But first, the individual taxpayer has to become aware of the error within that time.
Another complexity that may accompany a Roth IRA conversion is the unrelated business income tax (UBIT), a tax imposed to discourage exempt entities from competing in the business arena with taxable enterprises.
IRC Section 511 generally imposes a tax on unrelated business income of exempt organizations, qualified plans, and IRAs. Unrelated business income includes, for example, income from an operating business as well as income and gains from certain debt-financed property. Corporate income tax rates apply to some entities, while trust rates apply to others, depending on the type of organization subject to the tax. The tax is reported on IRS Form 990-T.
IRC Section 408(e) provides that IRAs are subject to the UBIT. For this purpose, IRAs are treated as exempt trusts subject to trust income tax rates. The Roth IRA rules in IRC Section 408A generally provide that every Roth IRA is a traditional IRC Section 408 IRA in all respects, except as otherwise provided in Roth IRC Section 408A. The Roth IRA provisions don't mention the application of the UBIT to traditional IRAs. Because of that silence, Roth IRAs are subject to the UBIT.
When a Roth IRA conversion occurs and the assets held in the retirement account being converted generate unrelated business income, which account pays what portion of the UBIT for that calendar year?
Treasury Regulations Section 1.6012-3(a) provides return filing rules for fiduciaries of estates and trusts. That regulation imposes the Form 990-T filing obligation on the trustee of each trust subject to the tax.9
It is always the trustee or custodian who must file and sign Form 990-T for it to be a valid, timely filed return. As noted, an IRA, including a Roth IRA, is always treated as a trust by statute for all IRC purposes. And the IRA trustee or custodian is always treated by statute as the trustee of that trust for all IRC purposes. No trustee has the ability to delegate to another the duty to file any return. Thus, the individual for whose benefit the IRA is held is never the trustee and should never sign Form 990-T.
Trustees may not combine trusts for tax filing purposes, even if the trusts “were created by the same grantor for the same beneficiary or beneficiaries.”10
Thus, it appears that if one traditional IRA and one traditional Roth IRA each exist in the same tax year, they will be treated as two separate trusts for Form 990-T reporting purposes. Clearly, if the account being converted is a non-IRA account (for example, a profit sharing account), that account and the Roth IRA will also be treated as two separate trusts for Form 990-T reporting purposes.
Accordingly, transferring investments that produce unrelated business income subject to the UBIT won't cause the UBIT liability of the transferring trust (IRA or other retirement account) to transfer to the Roth IRA. Instead, the unrelated business income must be apportioned according to the change in ownership during the year, and the resulting UBIT liability of each trust must be paid by each respective trust.
It will be important to keep open a converted retirement account until after the time when a re-characterization may be made. It will be necessary to keep funds in the transferring account sufficient to pay its UBIT liability. If the transfer is from an IRA and enough funds aren't retained by the converted account to pay its tax, it should be possible to re-characterize cash held from the transferee Roth IRA back to the traditional IRA account. A re-characterization can't be relied on to provide funds to the transferring IRA after the extended due date of the individual's income tax return for the year of the Roth IRA conversion because that's the last day for making a re-characterization.
Another reason to keep a converted IRA account open is to avoid early closing of the traditional IRA's tax year. An early account closing will accelerate the time for filing the return and paying the UBIT. Keeping the account open will be particularly helpful if the amount subject to tax is determined by an investee, such as an investee treated as a partnership for purposes of income tax reporting. In such cases, the tax information needed to compute the IRA's unrelated business taxable income typically won't arrive on time for any other year-end besides a calendar year.
When a Roth IRA conversion is made from a traditional IRA and is later re-characterized back to that same traditional IRA, Treas. Regs. Section 1.408A-5, Q&A-3 provides the traditional IRA is treated as owning the re-characterized assets from the date that the conversion occurred. For example, when a Roth IRA conversion from a traditional IRA is made on Jan. 4, 2010 and that entire Roth IRA is re-characterized back into that same traditional IRA on Oct. 10, 2011, the traditional IRA is treated as owning the re-characterized assets from Jan. 4, 2010 forward. The Roth IRA is treated as having never owned the re-characterized assets.
What that means for unrelated business income is that the Roth IRA reports none of its share of the year's unrelated business income. Instead, the converted traditional IRA that receives back its converted assets reports it all.
There's a possible mismatch in extended due dates. IRS Form 990-T, used for reporting unrelated business taxable income, is due the 15th day of the fourth month of the year (typically April 15th). Re-characterization may occur as late as the extended due date of the individual's return, typically Oct. 15th. It may therefore be best to extend the filing date for Form 990-T if the individual's personal income tax return is extended. Here's the possible mismatch: while there's an automatic six-month extension of time to file an individual income tax return, there's only a three month automatic plus a three-month non-automatic extension available for the Form 990-T.
When debt-financed assets are transferred to a new owner and that new owner assumes the debt, the transferor's debt relief usually results in a partial sale or exchange of property. Thinking once more of an IRA or other retirement account as one trust and a Roth IRA as another, transferring assets that are subject to a loan, such as real estate, might be viewed as relieving the transferring trust of debt. That, in turn, could create unrelated business taxable income under IRC Section 511. Debt-financed real estate is one example.
But that shouldn't be the case. When a Roth IRA conversion is made, the property rolled over or transferred to the Roth IRA is treated as though that property is distributed in a fully taxable distribution. In addition, the Roth IRA conversion must satisfy the IRC Section 408A(e) definition of a “qualified rollover contribution.” Thus, converted property is always treated as being first distributed from the converted retirement account to the individual taxpayer, who then is deemed to have contributed that property to the Roth IRA. The income tax basis in the property contributed to the Roth IRA must be the converting taxpayer's basis in the distributing plan, if any, plus the amount of taxable income realized as a result of the deemed taxable distribution. The sum of those two amounts should equal the fair market value of the property converted to the Roth IRA. The property can't both be treated as a taxable distribution to the individual taxpayer and a transfer involving debt relief between the converted account and the Roth IRA. So, there should be no debt relief income in the converted account that could trigger unrelated business taxable income.
The truly risk-averse will want to pay off the debt before making the conversion. This will completely avoid any argument there was debt relief income on conversion.
There's a further consequence to treating the Roth IRA conversion as a taxable distribution followed by a contribution to the Roth IRA. The basis of the property in the hands of the individual making the conversion will become the income tax basis of that property in the hands of the Roth IRA trustee.
For UBIT purposes, that should mean depreciation will begin anew, using its fair market value as of the date of conversion as basis.
In the end, Roth IRA conversions aren't just for marketable securities. Nontraditional investments can also be converted. So go ahead: Just take a little extra care to do it.
— The author thanks Natalie B. Choate, Christopher R. Hoyt, Eric Wiksrom, Ann Siford, and Susan Farkas for their invaluable assistance with this article.
Internal Revenue Code Section 408A. All references are to the IRC and related regulations.
IRC Section 408(a)(3).
IRC Section 408(m).
IRC Section 1361 permits ownership by organizations exempt under IRC Section 401(A), relating to qualified retirement plans; and Sections 501(A) and 501(c)(3), generally relating to certain charitable organizations. IRAs are not exempt under any of those provisions; rather, they are exempt under Section 408(E)(1).
IRC Section 408(a) provides, in relevant part: “For purposes of this section, the term ‘individual retirement account’ means a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries…”
IRC Section 408(h) provides: “For purposes of this section, a custodial account shall be treated as a trust if the assets of such account are held by a bank (as defined in subsection (n)) or another person who demonstrates, to the satisfaction of the Secretary, that the manner in which he will administer the account will be consistent with the requirements of this section, and if the custodial account would, except for the fact that it is not a trust, constitute an individual retirement account described in subsection (a). For purposes of this title, in the case of a custodial account treated as a trust by reason of the preceding sentence, the custodian of such account shall be treated as the trustee thereof.
IRC Section 408(d)(1).
The list of acceptable precious metals is found in IRC Section 408(m)(3). See also IRS Publication 590, stating, “Your IRA can invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion.” IRS Notice 87-16, 1987-1 C.B. 446 adds: “An investment by an IRA in a coin which has been made into jewelry is still considered an investment in a collectible, and will be treated as a distribution.”
Treasury Regulations Section 1.6012-3(a)(5). provides: “Every fiduciary for a trust described in section 511(b)(2) which is subject to the tax imposed on its unrelated business taxable income by section 511(b)(1) shall make a return on Form 990-T for each taxable year if the trust has gross income, included in computing unrelated business taxable income for such taxable year, of $1,000 or more. The filing of a return of unrelated business income does not relieve the fiduciary of such trust from the duty of filing other required returns.”
Treas. Regs Section 1.6012-3(a)(4). Also, the instructions to Form 990-T list IRAs and Roth IRAs separately, further suggesting that a traditional IRA is a separate trust from a Roth IRA for purposes of filing Form 990-T.
Michael J. Jones is a partner in Monterey, Calif.'s Thompson Jones LLP and chairs the Trusts & Estates Retirement Benefits Committee